SECURITIES

OPERATIONS

Day Trading Requires

Continued Oversight

United States General Accounting Office

GAO Report to Congressional Requesters

February 2000

GAO/GGD-00-61

United States General Accounting Office General Government Division

Washington, D.C. 20548

Page 1 GAO/GGD-00-61 Day Trading

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February 24, 2000

The Honorable John D. Dingell

Ranking Minority Member

Committee on Commerce

The Honorable Ron Klink

Ranking Minority Member, Subcommittee on Oversight and Investigations

Committee on Commerce

The Honorable Edward J. Markey

Ranking Minority Member, Subcommittee on Telecommunications,

 Trade, and Consumer Protection

Committee on Commerce

The Honorable Edolphus Towns

Ranking Minority Member, Subcommittee on Finance

 and Hazardous Materials

Committee on Commerce

House of Representatives

The Honorable Carl Levin

Ranking Minority Member, Permanent Subcommittee on Investigations

Committee on GovernmentalAffairs

United States Senate

This report responds to your February 11 and March 26, 1999, requests that

we review a number of issues regarding day trading. Day trading is a

strategy that generally involves making multiple purchases and sales of the

same security during the day to profit from short-term price movements.

You were concerned that day trading raises serious investor protection

and market integrity issues, particularly that investors have lost large

amounts of money from the questionable practices of day trading firms.

You were also concerned about the adequacy of risk disclosures to

investors by firms that specialize in day trading and the actions taken by

regulators in overseeing day trading. As agreed with your offices, our

objectives were to (1) determine the nature and extent of day trading, (2)

assess regulatory actions taken to address the day trading risks, and (3)

assess the actions day trading firms have taken to address regulatory

concerns.
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To address these objectives, we focused our work on seven of the largest

day trading firms. These firms have about 5,300 day traders, or nearly 80

percent of the 7,000 day traders whom regulators estimate trade in the

United States. An industry representative estimated that these seven firms

accounted for over 80 percent of all day trading volume. We also reviewed

the results of 67 examinations of day trading firms and their branch offices

done by federal regulators.

Day trading among less experienced investors is an evolving segment of

the securities industry. Day traders, who represent less than 1/10th of 1

percent of all individuals who bought or sold securities, accounted for a

growing part of trading on Nasdaq, estimated by industry officials to be

about 10 to 15 percent of total Nasdaq volume. These traders all did their

trading at specialized day trading firms, but the firms employed various

structures and operating strategies that affected the risks the traders

faced. Some firms encouraged any individual who wanted to be a day

trader, and had the capital to begin trading, to use the firm’s systems and

facilities to trade, risking the trader’s own capital. Others emphasized that

they wanted only people who were qualified and able to be professional

traders to trade, risking the firms’ capital. These traders could be fired if

they suffered significant loss, but they do not lose their own capital. Some

firms employed a combination or variations of these strategies.

The effects of day trading on both the individuals who engage in it and the

markets as a whole are uncertain. For example, day trading is risky, and

state regulators have reported that most individual day traders they

investigated lost money. However, officials at day trading firms we visited

said that although most people lose money initially, the majority of their

experienced traders (those that traded longer than 6 months) made money.

Two firms supplied us records that showed many of their traders were

extremely profitable; however, other firms did not supply records, and we

could not verify the extent of profitability in the industry as a whole. From

a market standpoint, day traders’ access to the markets provides direct

competition for market makers and institutional traders that may benefit

all individual investors, but day traders’ frequent trading during the day

also could potentially make market prices more volatile. Gaining a better

understanding of the effects of day trading on individuals as well as the

markets could help regulators better ensure that investor protection and

market integrity objectives are met.

Federal regulators have taken some actions to address the risks of day

trading. The regulatory arm of the National Association of Securities

Dealers, called NASD Regulation (NASDR), and the Securities and

Results in Brief
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Exchange Commission (SEC) have made a special effort to target their

examination resources during the last 2 years on day trading firms,

performing 67 examinations of day trading firms and their branches.1

 They

were concerned that these firms were advertising day trading as a

profitable strategy without fairly representing the risks associated with day

trading. The rule violations found most frequently in their examinations of

day trading firms related to supervisory procedures, net capital

computations, and advertising. They also found violations involving margin

and lending issues.2

 In addition to these examinations, NASDR has recently

submitted proposed rule changes to SEC that require day trading firms to

assess the appropriateness of day trading for each potential customer and

to fully disclose the risks of day trading. NASDR and the New York Stock

Exchange (NYSE) have also submitted proposed rule changes to SEC to

tighten margin requirements.

Some of the day trading firms we visited recognized these regulatory

concerns and told us that they have already taken steps to provide better

disclosure; screen prospective traders; and restrict certain activities, such

as customer-to-customer lending. The risk disclosure statements from all

of the firms we visited contained language the same as or similar to that in

NASDR’s proposed risk disclosure statement. Determining the adequacy

and extent of oral disclosures, screening, and planned restrictions presents

a difficult challenge because neither the regulators nor we could directly

observe the interactions between the firms and traders or potential

traders. However, ongoing implementation of such controls by firms and

oversight by regulators are important for ensuring that potential day

traders understand that they are directly competing with professional

market makers and institutional traders and can lose as much as, or more

than, they have invested.

We are making a recommendation to the Chairman, SEC, in conjunction

with NASD, to evaluate the implications of day trading on the integrity of

the markets after decimal trading is implemented. We are also

recommending that the Chairman, SEC, do at least one more cycle of

targeted examinations of day trading firms to ensure that the firms take

the corrective actions they propose in response to previous examination

findings.

 

1

 SEC and NASDR are responsible for ensuring investor protection and market integrity in the

securities markets.

2

 Margin is the amount of cash or securities a customer must maintain with a firm in order to obtain a

loan.
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Day trading requires a continuous stream of current market data and the

ability to trade without delay. Numerous day trading firms have developed

sophisticated order routing and execution systems as well as software that

can be used on computerized workstations. These systems enable day

traders not only to monitor the market on a real-time basis, but also to

trade on a real-time basis—similar to practices followed by professional

traders at proprietary firms. The order routing and execution systems of

these firms allow day traders to be linked directly to the stock markets,

enabling the traders to send orders to a particular market or market maker

without involving an intermediary firm. As a result, day traders have the

tools to employ the trading strategies and techniques that were previously

available only to market makers.

SEC has stated that over the last 3 years some day trading firms have

focused on marketing day trading as a strategy to investors, and these

firms have emphasized the opportunity for individuals to profit from day

trading without fully disclosing the risks. Reports have surfaced about day

traders who have lost money and claimed they were not informed of the

risks. SEC and NASDR are focusing their efforts on trying to ensure that

day traders completely understand not only the risks associated with day

trading, but also that there are high costs that can result from frequent

trading.

Although investing in securities always involves some degree of risk, day

trading involves a higher degree of risk of loss because of the way it is

conducted. Day traders try to anticipate market movements and profit

from short-term price movements in individual stocks. Using this strategy,

day traders trade frequently, incurring commissions and fees for computer

and electronic services provided by the day trading firm that can

significantly reduce a trader’s earnings. Furthermore, unlike investing

through a full-service broker-dealer, who may be responsible for

determining whether a particular trade is suitable for the investor, day

traders typically are the only ones accountable for their trading decisions.

Day trading typically requires direct electronic access to the markets. Day

trading firms provide order entry terminals to Nasdaq as well as NYSE.

Day trading is primarily transacted through Nasdaq, which is an electronic

communications system where market makers display prices at which they

are willing to buy or sell stocks for their own accounts or for their

customers. In the last few years, day trading has also been transacted

through electronic communications networks (ECNs), which allow

customers to display their orders to other customers and also allow

customer orders to be paired. ECNs are primarily used to access Nasdaq.

Background
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However, they may also be used to trade stocks listed on exchanges. Day

traders also have electronic access to listed stocks through the Superdot

system, which is an electronic order delivery system that links NYSE

member firms to individuals on the floor of an exchange who execute their

orders.

Regulatory changes to Nasdaq spurred the development of electronic day

trading. Nasdaq first introduced electronic executions when it developed

the Small Order Execution System (SOES) in 1985.3

 The system was not

fully implemented until 1988 when SEC required all market makers to

participate.4 Nasdaq also introduced SelectNet in 1990 as a system for

market makers to communicate and to execute transactions electronically

with each other.

Shortly after market maker participation in SOES became mandatory, a

few firms realized that they could profit from using SOES. These firms

became known as SOES day trading firms, and market makers called them

SOES Bandits.5

 Nasdaq market makers did not like losing profits to SOES

day traders. As a result, NASD proposed various SOES rule changes to

limit the activity of day traders. However, a series of events between 1993

and 1996—including an investigation of market makers’ possible

collusion—affected how SOES day traders were viewed in the market. As

a result of these events, NASD and SEC implemented several rules

changes. In January 1997, NASD implemented SEC’s order handling rules.6

These rules required Nasdaq market makers to display customer limit

orders and to disseminate the best prices placed by market makers in

 3

 SOES allows small orders placed through it to be automatically executed against Nasdaq market

makers at the best bid (buy) or ask (sell) prices displayed on the Nasdaq system. It allows customers to

access and trade with market makers without having to call them on the phone.

4

 The requirement was a direct result of the market makers’ poor performance during the 1987 crash.

At that time, market makers failed to answer their phones to honor their quoted prices, and customers

could not get orders executed at any price. In response, Nasdaq implemented an automatic electronic

execution system for customers through SOES.

5

 The trading strategy used by SOES day traders was one of looking for the beginning and end of a

trend—specifically the trends of market makers—and trying to buy and sell a stock using SOES and

SelectNet while the stock was moving in price. Because of the automatic execution feature of SOES,

day traders had a trading advantage over market makers and their customers in that they could

execute trades faster than the market makers could update their quotes. This ability allowed SOES day

traders to profit at market makers’ expense from short-term price movements in stocks.

6

 SEC intended these rules to make the Nasdaq market a more competitive, customer order-driven

market and thus reduce bid-ask spreads. As a result of the order handling rules, market makers have to

fill or display any customer’s limit order that improves on the inside price. This gives the customer’s

limit order protection in the market, as opposed to just having the market maker execute the order

when conditions were favorable to the firm.

Electronic Day Trading Has

Changed
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ECNs, which previously were not included in the Nasdaq market.7 NASD

also implemented actual size rules that allowed market makers to display

quotes in minimum sizes of 100 shares for certain stocks, which had the

impact of limiting the use of SOES by day traders because the trade size

fell from 1,000 shares to 100 shares. As a result, SOES day trading firms

began to develop and use ECNs in order to continue to provide day traders

access to the market without the limitations of SOES that resulted from

the rule changes. 8

With the decline in the use of SOES, day trading firms began to evolve into

customer-based firms that offered their traders direct access to ECNs,

SelectNet, Nasdaq, and the major stock markets. Moreover, the inclusion

of ECNs in the Nasdaq market enabled ECNs to explode in popularity, and

these networks have become the choice of trading for day traders,

according to industry officials.9

 According to industry statistics, ECNs

account for 30 percent of the Nasdaq trades. In fact, one of the largest

ECNs was created by a day trading firm.

Day traders’ use of ECNs has meant that not only has the venue they use to

trade changed, but whom they trade with has also changed. ECNs allow

orders to be paired or traded with each other. By trading on ECNs, day

traders are trading more and more with each other and less and less with

market makers.10 For instance, one firm estimated that 35 percent of its

order flow would match internally if was conducted within a single ECN.

ECNs are also designed to handle limit orders, and the increased use of

ECNs has resulted in the increased use of limit orders.11 Before 1997, day

 

7

 Limit order is a customer order to buy and sell a security at a specific price.

8

 One ECN, Instinet, already existed, but it could be accessed only by institutions.

9

 One reason ECNs are popular is that as spreads narrow on volatile stocks, market makers are more

inclined to step aside and post trades into ECNs, where investors can trade directly with one another.

Another reason is that investors can save money because fees are low and because they can effectively

negotiate prices with limit orders. ECNs match up potential stock buyers and sellers directly while

allowing customers to maintain anonymity.

10 When Nasdaq was first developed, it attracted illiquid stocks that did not meet the New York Stock

Exchange’s or the American Stock Exchange’s listing requirements. Nasdaq market makers typically

quoted wide spreads (the difference between the bid and the ask price), reflecting the nature of illiquid

stocks. In addition to the wide spreads, Nasdaq ensured that market makers were able to earn the

spread on every transaction. A market maker was always on the other side of every trade. This meant

that customers were rarely allowed to trade with each other. They were forced to buy and sell stocks

from a market maker who would benefit from wide spreads.

11 The open limit order display system gives orders greater market representation, which increases the

possibility of matches. Orders that are not immediately matched are typically displayed for all

subscribers to see.
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traders were submitting most of their orders as market orders through

SOES. The Electronic Traders Association (ETA) estimated that limit

orders constitute nearly one-half of day trader orders, which they said

helps to improve prices. They stated that if a market maker quoted a stock

at 50-50-1⁄4, a customer limit order of 50-1/8 would effectively narrow that

spread, thereby improving prices for all investors. Industry and regulatory

officials have stated that limit orders are now a part of the quote montage

(all listed quotes), and the inside price (best price) may well be set by a

public order from a day trader.

To determine the nature and extent of day trading, we collected data from

day trading firms, SEC, NASDR, and ETA. We identified the largest day

trading firms through industry and regulatory sources and focused our

study on the seven largest firms. Officials from another large firm told us

that officials from a firm we visited could speak for them, and they chose

not to talk to us. We obtained data on the number of day traders from the

firms that we visited. When possible, we also cross-checked those

numbers with any data found in SEC and NASDR’s examinations of those

firms. To determine the nature of day trading, we interviewed officials of

the seven day trading firms about how day trading was conducted at their

firms. We also spoke to ETA about the overall nature of day trading, and

we reviewed the regulatory examinations of day trading firms for

information on the nature of day trading. To obtain opinions and data on

the profitability of day traders, we interviewed officials from the seven

largest firms about the profitability of their traders, and we reviewed data

from two of the firms. We did not assess the reliability of data gathered

from these sources.

To identify regulatory actions taken to address the risks of day trading, we

reviewed the 67 examinations that NASDR and SEC did during 1998 and

1999. We determined the frequency of the violations and the actions SEC

and NASDR were taking against day trading firms for the violations. We

also interviewed state securities officials from Texas and Massachusetts,

the two states that had taken action against day trading firms, and an

official from the North American Securities Administrators Association

(NASAA) who was the main author of that Association’s report on day

trading. Additionally, we interviewed NASDR and SEC officials about the

proposed rules for day trading firms, and we reviewed the rules and public

comment letters relating to the rules. Lastly, we reviewed related

congressional testimonies of NASD, SEC, and ETA officials.

To identify actions day trading firms have taken to address regulatory

concerns, we interviewed officials from the seven day trading firms we

Scope and

Methodology
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visited about the initiatives they were taking pertaining to issues regulators

were concerned about such as customer-to-customer lending, risk

disclosure, margin issues, and appropriateness determinations. We also

obtained each firm’s risk disclosure statements and compared them to

NASDR’s proposed disclosure statement to determine if they appeared to

be line with NASDR’s proposal. Additionally, we talked to ETA, the

Securities Industry Association (SIA), and legal representatives of day

trading firms to get their views about the firms’ initiatives. We also talked

to Federal Reserve officials about current margin requirements that

pertained to securities firms.

We requested comments on a draft of this report from SEC and NASDR.

Their comments are discussed near the end of this letter and reprinted in

appendixes I and II. We did our work in accordance with generally

accepted government auditing standards between July 1999 and January

2000 in Washington, D.C.; Houston and Austin, TX; New York, NY; and

Montvale and Jersey City, NJ.

Day trading is different from on-line trading or trading through a full

service broker. Day trading is usually conducted on-site at firms that offer

technology that is superior to the technology offered by on-line trading

firms. These firms have developed order routing and execution systems

that allow day traders to trade directly into the market with no

intermediary, which is something an individual has never before been able

to do. The firms that we visited had different structures and operating

strategies, with the common characteristic that their traders used day

trading strategies. Although state regulators have reported that most day

traders lose money, officials at six of the firms we visited said that most of

their experienced traders were profitable. The effects of day trading on the

markets have been controversial, but we found no overall analysis of the

benefits and costs of day trading.

Nature and Extent of

Day Trading
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Day traders attempt to profit from small movements in the prices of stocks

over a short time period. For example, they try to anticipate the likely

move of a stock in the next few minutes or hours, buying and selling

quickly, and generally hoping for a small profit (this could be as little as 25

cents a share) on a large number of shares (averaging about 1,000). Day

traders are generally momentum traders—hoping to buy when prices are

increasing and sell before prices fall or sell when prices are decreasing and

buy back before prices rise. Most day traders also try not to carry positions

overnight.

As a result of their trading strategies, day traders are not considered to be

investors. They do not pay close attention to such factors, as

price/earnings ratio or investing and earnings models, which investors are

taught to follow. They do not hope to gain by buying and holding shares

over extended periods of time.

Day trading is also different from trading on-line, although the distinctions

between them are beginning to blur. On-line trading provides investors a

cheaper, faster way to place orders with their brokerage firms than

contacting them by telephone. On-line traders may use any number of

trading strategies designed to profit from either short-term or long-term

favorable price movements in the stocks they buy and sell. On-line traders

may also employ day trading strategies, but these traders generally lack

the access to the markets and instantaneous updated prices that day

traders have.

A day trading firm provides its traders with direct access to the markets

through the firm’s order router, which instantaneously sends orders to the

market location with the best price by interfacing directly with the major

stock markets and ECNs. As a result, day traders send their orders to a

particular market without having an intermediate firm involved in routing

the order. In doing so, day traders can receive a trade execution within

seconds of placing their orders, which is necessary for them to be able to

capitalize on small price movements in stocks.

Day traders’ direct access is different from the access to the markets

provided by many on-line trading firms. These on-line trading firms may

take customer orders and either match them internally or sell them to a

specific market maker in return for payment for order flow. In these

arrangements, the market maker pays a penny or more a share for the

order flow created by the on-line firm’s customers and is to provide the

customer an execution at the best prevailing quoted prices.

How Day Trading Is

Conducted

Direct Access to the

Markets Versus Payment for

Order Flow
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The distinctions between on-line firms and day trading firms are becoming

less obvious as these industries develop. For example, on-line trading

firms are beginning to provide their frequent traders news and price quote

services similar to those already provided by day trading firms. Although

market makers, institutional investors, and day traders have direct access

to ECNs, a few on-line firms have decided to offer their customers some

level of direct access to ECNs or funnel some of their customer order flow

into ECNs. Additionally, some day trading firms are going after the active

trader at on-line firms by promoting the advantages of direct access to the

markets.

The technology and software that day trading firms provide enable day

traders to have real-time data and information as well as direct access to

the markets similar to what proprietary firms offer their traders. The

computer facilities, high-speed access lines, and software packages that

day trading firms use are specifically designed to support and

accommodate day trading. For example, these firms provide day traders

access to Level II data, which shows the best bid (buy) and ask (sell)

prices and the number of shares available for every market maker and

ECN. The Level II data are often provided by day trading firms with

extreme speed that enables day traders to capitalize on momentary

fluctuations in prices. Other software features of day trading firms include

• offering traders a broad view of the market, such as allowing them to open

up a list of hundreds of stocks and watch them update in real time;

• point and click order-entry windows that allow traders to send out orders

to different exchanges;

• real-time profit and loss windows;

• fundamental data on companies;

• ticker features; and

• programmable key strokes that allow traders to specify any function key

combination for order entry functions;

Technology and Software of

Day Trading Firms
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Figure 1 provides an example of the type of information and software in a

mainstream application that day trading firms offer day traders.
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Figure 1: Typical Trading Screen for Day Traders
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Source: Information on the screen was provided by TradeCart as modified by GAO.

Day trading firms are typically organized as (1) broker-dealers that have

customers who open accounts with the firm and use the assets in their

own accounts to trade; or as (2) limited liability companies (LLC), which

sell an interest in the firm to individuals wishing to day trade. As brokerdealers, these firms must register with SEC, and they are subject to SEC

rules and regulations. Broker-dealers with customers are also required to

be members of NASD and are subject to NASDR rules. LLCs are also

registered broker-dealers, but individuals who day trade at these firms

typically are not customers; they become part owners of the firms and are

called associated persons. These firms allow their associated persons to

trade using a portion of the firms’ capital contribution. Many LLCs are

members of the Philadelphia Stock Exchange and are subject to its rules.

The seven day trading firms we visited were all registered broker-dealers,

six were NASD members, and one was an LLC that was a Philadelphia

Structures of Day Trading

Firms Pose Different Risks

to Day Traders
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Stock Exchange member. These structures affect the risks faced by the

day traders at the firms.

The structures and operations of the firms we visited were very different.

Three firms had mostly registered proprietary day traders, who traded on

behalf of the firms and the firms’ customers. They also had a few

nonproprietary day traders who traded using their own capital and the

firms’ software and facilities. One of these firms was completely unique in

that it had only four registered proprietary day traders trading on behalf of

about 19 investors and had no nonproprietary day traders. This firm did 80

percent of its trades automatically through specially designed software

programs and 20 percent by its proprietary traders, and it traded almost 10

million shares a day. The other four firms had mostly nonproprietary day

traders and a few proprietary traders.

Officials at five of the day trading firms we visited asserted that they were

selective about whom they allowed to trade at their firms. They said they

looked for individuals who would approach day trading in a professional

manner and eventually become professional traders similar to the traders

at market making firms. In general, these firms tended to already have a

high percentage of proprietary traders and were looking to hire more

individuals who would be proprietary traders. One firm said that it was

moving away from having nonproprietary day traders towards having only

proprietary day traders. However, officials at two firms said that as long as

individuals met the initial capital requirement, which was at least $25,000,

they would allow anyone to trade.

Nonproprietary day traders trade using their own money and risk losing as

much as, or more than, they have invested. Proprietary day traders who

trade at LLCs typically are limited partners that have invested their own

money into the firm in order to trade, risking the accumulated capital of

the limited partners. In many cases, these proprietary traders’ potential

losses are limited to the amount of their initial investments. Rules designed

to ensure that day traders understand their risks of loss and the pitfalls of

trading on margin or with borrowed funds carry added significance for any

day trader whose own money is at risk. However, we found some non-LLC

day trading firms that hire proprietary traders to trade, risking the firms’

money or that of investors in the firms. These traders can be fired if they

continually lose the firms’ money, but their risk of loss is different because

they do not risk their own money. None of the investors in these firms had

filed any complaints with securities regulators.
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Day traders are few in number, but they account for a growing amount of

the Nasdaq trading volume. SEC estimated that about 7,000 people are day

traders at day trading firms. By comparison, about 80 million individuals

own stock, and more than 5 million use on-line brokerage firms. As a

whole, day traders represent less than 1/10th of 1 percent of all individuals

buying and selling stocks. SEC also estimated that there are about 100 day

trading firms operating, with hundreds of offices around the country,

which is a small part of the nearly 8,000 registered broker-dealer firms.

However, NASDR and SEC officials said they could not be sure of the total

number of day trading firms because these firms are required to register

only as broker-dealers, not as day trading firms. ETA estimated that there

are 62 on-site day trading firms.

Day trading firms account for an estimated 10 to 15 percent of the total

Nasdaq trading volume in 1999, according to industry officials. Their

trading volume has steadily increased over the last few years. In 1997, day

trading firms as a whole represented an estimated 7.7 percent of the

Nasdaq trading volume. As of year-end 1999, we estimated that the seven

firms we visited represented about 9 percent of Nasdaq’s trading volume.

An industry report estimated that on-site day traders were responsible for

11 percent of the Nasdaq trading volume during the first quarter of 1999.12

ETA has consistently said that day traders represent about 15 percent of

the Nasdaq trading volume.13

Day traders trade more often than the average trader placing orders

through a brokerage firm or on-line. The firms we visited told us they

generally executed anywhere from about 2,700 trades a month to about 1.8

million trades a month. On a yearly basis, day traders at the firms made

anywhere from 33,000 trades a year to about 22 million trades a year.14 In

contrast, one industry study stated that the average full-service brokerage

customer conducts between 6 and 12 trades a year, and the average on-line

investor conducts between 15 to 25 trades a year.

Whether day trading is profitable is the subject of much debate within the

securities industry. State securities regulators have estimated that more

than 70 percent of day traders lose money, and only about 12 percent

demonstrate the capacity to be successful. Moreover, ETA officials stated

 

12 See Gregory W. Smith, “The Electronic Brokerage Industry,” Hambrecht & Quest, October 5, 1999.

13 Ibid.

14 Our figures are based on the average number of daily trades done by all the traders at each firm,

assuming 20 working days in a month.

Extent of Day Trading

Profitability of Day Traders
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that the risk of loss in day trading can be substantial. It estimated that the

learning period for day trading is about 3 to 5 months, and not only will

most people lose money in that period but a substantial number of day

traders will never be successful. However, officials at six of the seven

firms that we visited said that the most of their experienced traders were

profitable.

All of the firms we visited agreed with ETA’s estimate that it takes

individuals from 3 to 5 months to be profitable. Some of the firms said that

although they have had individuals leave during the 6-month period, none

had experienced a high turnover rate because of unprofitability. However,

two firms said that they had asked individuals who, in their estimation,

could not be profitable day traders to leave.

One of the firms that we visited published the profitability of its day

traders on its Web site. The data showed that 47 percent of its traders

made money after commissions in 1998, and 52 percent made money in

1999.15 We estimated that of the 47 percent who made money, 74 percent—

35 percent of the total number of traders—beat the return of the Standard

& Poor’s index of 500 (S&P 500) stocks in 1998.16 In 1999, 55 percent of this

firm’s traders made money. We estimated that of the 55 percent who made

money, 78 percent—43 percent of the total number of traders—beat the

return of the S&P 500. In comparison, industry statistics show that less

than 25 percent of all stock mutual funds have been able to beat the return

of the S&P 500 in the last few years. The other six firms that we visited told

us that many of their experienced traders were profitable. These firms did

not, however, publish data on the profitability of their traders on their Web

sites. Further, day traders have achieved these results during an extended

bull market.

Day trading firms we visited said they make a profit from day traders’

activities. These firms charge commissions on each trade made by day

traders as well as fees for computer and electronic services provided by

the firms. The firms that we visited said that they net about $2 or more on

each trade. Using the data from 1 firm that had 500 traders conducting

about 20 trades a day, we estimated that the firm nets about $20,000 a day.

 

15 This particular firm required $75,000 initial capital contribution. Our estimate was based on the

individual having $100,000 in capital. The 1998 return of the S&P 500 was 19.3, and the 1999 return was

19.5. We did not assess the reliability of these numbers from the firm.

16 The firm provided more specific data to us on individual traders. We did not assess the reliability of

these data.
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Some firms netted more than that amount, and others netted less. Officials

at one firm said that the firm’s daily net profit was about $150,000.

The effects of day trading in its current form are unknown. When day

traders primarily traded through SOES, several studies analyzed the effects

of SOES trading on spreads, liquidity, and volatility. Our previous review of

these studies found that they could not isolate the effect of SOES trading

from that of other changes in the market.17 The effects of day traders in the

more recent environment, which depends less on SOES and more on

ECNs, have not been similarly assessed.

Industry officials have said that day traders have provided some benefits to

the markets. For example, as evidenced by their growing share of the

Nasdaq volume, day traders bring substantial liquidity to the markets.

These officials also said that the increased use of limit orders by day

traders has helped to improve price efficiency for all traders. For example,

when day traders enter a limit order that is between the best bid and ask

spread, they improve prices for all retail orders. Additionally, day trading

firms have also been an impetus behind the development and use of some

ECNs, which has enabled individuals, for the first time, to have direct

access to the securities markets.

On the other hand, as we reported in 1998, market participants have said

that day trading through SOES caused increased volatility in the market.18

They stated that the trading strategies of SOES day traders, such as the

momentum-based strategy of buying in “up trending” markets and selling

in “down trending” markets, have led to increased volatility. The studies

that examined volatility and trading through SOES showed that they were

related. However, the studies did not clearly establish whether SOES

trading caused volatility or whether other market forces caused volatility,

which then attracted SOES trading. Market and regulatory officials have

been concerned that the effects of day trading through ECNs are similar to

those they attributed to SOES trading. However, they have not yet

attempted to evaluate these effects. They have been primarily concerned

about the practices of day trading firms because some day trading firms

have violated securities rules and regulations and misled customers.

 17 See Securities Market Operations: The Effects of SOES on the Nasdaq Market (GAO/GGD-98-194,

Aug. 31, 1998).

18GAO/GGD-98-194.

Effects of Day Trading
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Over the last 2 years, securities regulators have focused their oversight

efforts on day trading firms through both targeted examinations and

proposed rule changes. NASDR and SEC performed 67 examinations of

day trading firms and their branches during this period.19 Although they

found no widespread fraud among the day trading firms, they found a

number of violations and are concerned about compliance with some

rules. The most frequently occurring violations involved rules relating to

written supervisory procedures, net capital computations, short sales, and

advertisements. The examinations also found violations relating to margin

and customer lending. During the same time period, NASDR and NYSE

have also proposed rules that would address some of the risks of day

trading. SEC is reviewing the rule proposals.

NASDR, NYSE, and SEC examine all securities broker-dealers on a cyclical

basis based on the risks they pose to their customers and the securities

markets. NASDR and NYSE examine all their member firms on a regular

schedule, and SEC examines a sample of broker-dealers each year to

assess the effectiveness of NASDR and NYSE examinations and to ensure

compliance with securities laws. These routine examinations review

various aspects of broker-dealer operations, including sales practices,

advertising, and financial integrity, among others. NASDR, NYSE, and SEC

also do “cause” examinations to address particular problem areas

identified through various means, such as customer complaints. They also

target high-priority areas for annual on-site inspections. During 1997 and

1998, NASDR and SEC targeted day trading firms because they were

concerned that the firms were marketing unrealistic expectations and

unsubstantiated representations about the profitability of day trading, but

not adequately describing the risks.

SEC and NASD officials told us that the violations found at the day trading

firms were generally similar to violations they find at most securities firms.

They said that when they find violations, they notify the firms and give

them 30 days to respond in writing, stating the steps that they are taking to

correct the violations. SEC officials said that if firms do not agree to take

necessary corrective actions, SEC examiners would either refer the matter

to SEC’s Enforcement Division for review or take other action. As of

January 2000, neither SEC nor NASDR had reexamined any of the firms or

branches they targeted in 1997 and 1998.

 19 SEC did 47 examinations of 41 separate firms and their branches. NASDR did 20 examinations, 15 of

which were of different firms than SEC examined. In total, SEC and NASDR examined 56 separate day

trading firms.

Securities Regulators’

Oversight of Day

Trading Firms Found

No Widespread Fraud

SEC and NASDR Targeted

Examination Resources at

Day Trading Firms
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Page 19 GAO/GGD-00-61 Day Trading

SEC and NASDR examiners may also refer firm conduct or violations that

they consider warrant investigation to SEC’s Enforcement Division for

further review. Their examiners referred 15 day trading firms to the

Enforcement Division. SEC officials said that the Enforcement Division’s

investigations of these firms relate to margin lending, net capital, brokerdealer registration issues, short sales, supervision, and advertising. The

investigations were ongoing as of February 16, 2000.

NASDR rules require each broker dealer to establish, maintain, and

enforce written procedures that enable it to supervise its registered

representatives and associated persons and that are designed to ensure the

member complies with applicable securities laws. Examiners are to review

a firm’s procedures and its books and records to determine if the firm is

enforcing and complying with the procedures.

During their day trading examinations, NASDR and SEC found 29

instances in which day trading firms failed to enforce their own written

supervisory procedures. Of the seven firms that we visited, two had such

violations. SEC and NASDR examiners found that firms violated rules or

failed to enforce internal supervisory procedures that

• forbade a registered representative or any person associated with the firm

from recommending securities or trading strategies,

• directed supervisory personnel to evaluate prospective clients by

reviewing a client’s income and type of employment,

• prevented employees from arranging for credit to a customer on terms

more favorable than available through other means, and

• required an annual review of branch offices.

In some cases, violations resulted from a firm’s failure to have appropriate

written supervisory procedures. For example, some firms

• failed to have procedures that addressed the lending of funds between

customers;

• failed to have procedures that addressed the types of business in which it

engaged;

• failed to have procedures that specifically supervised the type of business

in which it engaged (one firm advertised itself as a broker-dealer that

Written Supervisory

Procedure Violations
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specialized in on-line day trading, but it did not have procedures that

specifically supervised this type of business);

• failed to have procedures pertaining to short sale transactions; and

• failed to have procedures that addressed the disclosure of credit terms

between customers.

SEC and NASDR’s short sales rules prohibit investors from selling an

exchange-listed stock short unless the stock’s last trade or bid was at the

same price as or higher than the previous trade or bid.20 The purpose of

these rules is to keep firms and investors from exacerbating price

movements when markets are declining. NASDR also requires that

securities firms mark all sales as either “long” or “short” and that the firms

determine if they can obtain shares of the security sold short to deliver to

the buyer.21 SEC and NASDR examiners found 14 violations of short sales

rules. Of the seven firms that we visited, the regulators found two firms

that had violated the short sale rules.

The regulators also found that some day trading firms lacked the

surveillance systems needed to prevent and detect short sale violations by

day traders. They found that this was particularly true of day trading firms

that were organized as LLCs.22

Day trading firms, like all other broker-dealer firms, are required to comply

with the net capital rule. The net capital rule is a liquidity-based capital

standard that requires broker-dealers to (1) maintain a minimum level of

liquid capital sufficient to promptly satisfy all of its obligations to

customers and other market participants and (2) provide a cushion of

liquid assets to cover potential market, credit and other risks.23 Examiners 

20 A short sale refers to any sale of a security that the seller does not own or any sale that is

consummated by the delivery of a security borrowed by, or for the account of, the seller.

21 NASD rule 3370 also requires that broker-dealers keep written records of short sale affirmative

determinations that include, among other things, the identity of the individual and firm that offered the

assurance and the number of shares needed to cover the short sale.

22 A firm is supposed to have procedures that are designed to prevent a trader from selling on a

downtick when the firm’s aggregate position in the stock is short. However, when the firm does not

aggregate all of the positions of the traders at LLCs—known as associated persons—then the firm does

not know whether it is holding long or short positions in an individual security and could end up

marking short sales as long sales and vice versa.

23 Generally, a firm’s net capital is computed by deducting illiquid assets from its “net worth,” as

determined under Generally Accepted Accounting Principles, adding to that amount properly

subordinated debt under Appendix D of the net capital rule, and further deducting certain prescribed

percentages, known as haircuts, from securities held in the firm’s proprietary accounts.

Short Sale Violations

Net Capital Violations
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usually evaluate a firm’s net capital as of a given date. They are to check to

see whether the firm has computed its net capital and whether the

calculations were done according to the rules. Inaccurate computations

result in firms either overstating or understating their net capital or having

net capital deficiencies.

SEC and NASDR examiners found 16 examples of day trading firms either

not maintaining the required minimum net capital amount or not preparing

their net capital computations in accordance with the rules. Of the seven

firms we visited, one firm had violated the net capital rules.

NASDR reported that 80 percent of the day trading firms that it examined

had potentially problematic advertisements that had been referred to its

Advertising Regulation Department for review. The problem areas ranged

from exaggerated statements of profits that can be generated from day

trading to day trading Web sites and other communications with the public

that have indicated that losses can be controlled or minimized through the

use of certain strategies or techniques. SEC has also stated that it is

concerned about Web sites that, although not operated by day trading

firms, are trying to capitalize on day trading. Many of these sites appear to

advertise the potential rewards of day trading by use of the sites’

recommendation. SEC said it is looking into whether these sites are

violating the federal securities laws.

SEC and NASDR examiners found over 20 advertising-type violations. One

of the seven firms that we visited had advertising violations. The types of

advertising violations found at day trading firms included

• failure to maintain and evidence written approval by a registered principal

on one piece of sales literature utilized during the day trading seminar

sponsored by a branch office of the firms;

• failure of an affiliate of a day trading firm to file a pamphlet, which

appeared to contain misleading or exaggerated statements, with NASDR’s

advertising department;

• failure to refrain from making recommendations in advertisements;

• exaggerated or unbalanced statements advertising a trader’s profit; and

• failure to file initial advertisements with NASDR.

Advertising Violations
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SEC and NASDR found fewer violations relating to margin and lending

issues. Although these violations tended to be isolated, margin and related

customer lending are two issues that regulators believe are potential

problems with day trading firms because of the nature of day trading and

the way it is conducted.

Day trading generally occurs in margin accounts.24 Generally, a customer

that trades in a margin account is subject to the initial margin

requirements of Regulation T and the maintenance margin requirements

imposed by the SROs. The initial margin requirements under Regulation T

permit a firm to lend its customers up to 50 percent of the initial purchase

of stock.25 To comply with Regulation T, the customer would have to

deposit funds or margin securities equal to 50 percent of the purchase

price of the stock bought during the day and held in the account at the end

of the day. For instance, a customer who wants to buy $150,000 worth of

stock can put up $75,000 and then finance the other $75,000 with a loan

from the broker-dealer. Once stocks have been purchased, NASDR and

NYSE maintenance margin rules require a customer to maintain equity in

his or her account equal to at least 25 percent of the value of the stock held

in the account. For instance, a customer who bought $150,000 of stock on

margin would have to have equity in a margin account of at least $37,500. If

a customer does not satisfy these requirements, the broker-dealer must ask

the customer to deposit additional cash or margin securities to satisfy the

margin deficiency, known as a margin call. Thus, there are two separate

margin requirements for each account: one for the initial purchase of stock

and the other for the amount that has to be maintained on margin once

stock has been purchased. Both calculations are made at the end of the

day, and if a customer has not met the appropriate margin requirements, a

margin call is issued. Regulation T margin calls must be satisfied within

one payment period after the margin deficiency was created or increased,

which is generally 5 business days. NASDR and NYSE maintenance

margin calls must be satisfied as promptly as possible, and in any event

within 15 business days from the date the margin deficiency occurred.

Because initial and maintenance margin calculations are made at the end

of the day, the above requirements are generally not applicable to day

traders because their stocks are sold by the end of the day before the

 

24 A customer may purchase and sell a security on the same day in a cash account if the customer has

the money in the account. However, if the customer does not have the money in the account, a day

trade may amount to free riding—purchasing a stock and then selling it without having paid for the

purchase.

25 Regulation T is a Federal Reserve rule that specifies margin requirements. For example, it requires an

initial margin of 50 percent for new purchases of stocks in margin accounts.

Fewer Violations Relating to

Margin and Customer

Lending

Margin
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Page 23 GAO/GGD-00-61 Day Trading

margin calculations are made. Accordingly, NYSE and NASDR have also

established separate margin rules for day traders in order to addres this

and other concerns. Under NYSE and NASDR rules, when day trading

occurs in a day trader’s account, the margin requirement is calculated at

the end of the day based on the total cost of all the day trades made during

that day. 26

Regulators have found that some day trading firms that are structured as

LLCs allow their day traders to be highly leveraged. Under an LLC, a day

trader contributes to the firm’s capital and, as a result, is permitted to

trade using the firm’s capital. Accordingly, the day trader is not subject to

the margin requirements outlined above; rather, the day trader’s leverage is

limited by the firm’s overall net capital requirement. This enables a day

trader who is a member of an LLC to be leveraged far higher than the 2-to-1

leverage allowed day traders under initial margin and maintenance margin

rules. Regulators implemented margin requirements not only to protect the

financial integrity of broker-dealers that provide credit, but also to protect

customers from taking on too much leverage. The leverage afforded

through LLCs enables their day trading members to have much more

capital with which to trade, and their exposure to loss is much higher than

would be afforded to day traders of a broker-dealer firm that has a more

traditional structure and treats day traders as customers. As a result, some

day traders can be leveraged to a greater extent than was intended by

margin rules.

NASDR and SEC examiners found five margin violations. Of the seven

firms that we visited, one firm had margin violations. Margin violations

included the following:

• An account was allowed to trade when Regulation T margin requirements

had not been met.

• One firm’s customers did not make the required deposits of additional

margin into their accounts.

 

26 However, under a NYSE rule interpretation, if the broker-dealer keeps a record showing the “time

and tick” of each trade as evidence of the sequence of the day trades, the day trader may maintain

margin based on the largest aggregate open position during that day. In effect, this requires day traders

to demonstrate that they have the ability to meet the initial margin requirements of Regulation T for at

least their largest open positions during the day. For example, a day trader who makes 20 buy and sell

trades during the day and ends the day flat would receive a margin call based on 50 percent of the

largest open position held during the day, assuming that there was a margin deficiency in the account.

NASDR margin rules are substantially the same as NYSE’s rules. However, NASDR has not adopted

the “time and tick” interpretation regarding day trading margin.
B-283097

Page 24 GAO/GGD-00-61 Day Trading

• An associated person of the day trading firm extended credit to day traders

of the firm in amounts that exceeded the amount the firm is allowed under

under Regulation T.

SEC and NASDR found that some day trading firms allow the use of

customer-to-customer lending, where one customer lends money to

another who requires funds to meet margin calls.27 NASDR found that half

the firms that were examined allowed customer-to-customer lending.

Combined, SEC and NASDR examiners found 23 day trading firms that

allowed customer-to-customer lending. Of the seven firms that we visited,

three allowed customer-to-customer lending.

Although customer-to-customer lending is not illegal, regulators are

concerned about the practice, especially when such lending is used to

satisfy day traders’ margin requirements. Regulators believed that some

day traders would be unable to continue to trade without the infusion of

capital from the loans. NASDR expressed concern about customer-tocustomer loans that were arranged by the day trading firm or one of its

employees for the purpose of meeting margin calls. NASDR’s concern was

with the role of the day trading firm and what type of information was

conveyed to the borrower about the risks.

The lending violations that the regulators found related to disclosure of

credit terms in margin transactions and disclosure and other requirements

when extending or arranging credit in certain transactions. For instance,

Regulation T was promulgated to regulate the extension of credit by

broker-dealers; it defines a creditor to include any person associated with

the broker or dealer as defined in the Securities Exchange Act. Examiners

found that some day trading firms were extending credit to day traders at

the firm in violation of the rules. Examiners also found instances where

associated persons of the day trading firms extended credit to customers

without establishing procedures to ensure that day traders were given

disclosures related to the terms of the loan. Of the seven firms that we

visited, examiners found two firms had violations relating to lending.

NASDR and NYSE have proposed rules that would require day trading

firms to tighten margin requirements. NASDR has also proposed rules that

would require day trading firms to assess the appropriateness of day

trading for each potential customer and fully disclose the risks of day

 27 Regulators have also found that customer-to-customer lending may be facilitated by a day trading

firm that would work with its clearing firm to identify day traders with credit balances who would be in

a position to lend money to other customers.

 Lending

Proposed Rules Address

Some Regulatory Concerns
B-283097

Page 25 GAO/GGD-00-61 Day Trading

trading. Although NASDR’s Board had approved the rules, as of February

16, 2000, SEC had not approved them. SEC has issued the NYSE rules for

public comment.

Both NASDR and NYSE have proposed tightening the conditions under

which active day traders may trade stocks on margin. The NASDR

proposal would require that a pattern day trader—a day trader who trades

four or more times within 5 days—maintain a minimum equity of $25,000

at all times. If the account falls below $25,000, the day trader would be

barred from further day trades until the account is restored. In addition,

the proposed rules would require a special maintenance margin

requirement of 25 percent of the cost of the highest open position during

the day. The proposed rules would also reduce the time frame for day

traders to meet a margin call from 7 days to 5 days. Under the proposed

rules, if a day trader received a margin call, until the call is met, the

trader’s buying power would go to 50 percent and would be calculated

based on the trader’s cumulative positions, not the single highest position

as is currently permitted under NYSE interpretation. Moreover, if the

margin call is not met within the required 5 business days, no trades on

margin would be allowed for 90 days or until the margin call is met.

Furthermore, the funds that day traders deposit to meet their margin

requirements would have to stay in the account for at least 2 business days

in order to provide greater financial stability to day trading accounts.

NASDR’s proposed rule to require day trading firms to assess the

appropriateness of day trading for each new customer is similar to the

suitability rules NASDR imposes on broker dealers. Suitability rules

require broker-dealers that recommend securities products to investors to

make sure that the products are suitable for the investors, given the

broker-dealers’ knowledge of the investors’ objectives, finances, risk

tolerances, and so on.28 Because day trading firms do not generally

recommend particular products, they likely are not subject to the

suitability rules.29 However, the proposed appropriateness rule would

require NASD firms that promote a day trading strategy to (1) assess

whether such trading would be appropriate for each customer before

opening an account for the customer or (2) get a signed document

indicating that the customer is not going to use the account for day

 28 Suitability Rules refer to NASD Rule 2310 Recommendations to Customers.

29 Suitability applies only when a broker makes a recommendation. There can be no claim against the

broker for unsuitable investments when the broker does not make a recommendation.

Proposed Rules on Margin

Proposed Rule on

Appropriateness and Disclosure
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trading.30 The proposed rule does not expressly define what promoting a

day trading strategy would be. However, it does state that a firm would be

promoting a day trading strategy if the firm promoted day trading through

advertising, training seminars, or direct outreach programs. In essence, to

approve a potential day trader for trading, the day trading firm would be

required to determine whether day trading is appropriate for the individual

by reviewing such things as the day trader’s financial situation, investment

and trading experience, and investment objectives. Day trading firms

would be required to prepare a written record setting forth the basis on

which the firm had approved the account for day trading.

The proposed account approval procedures would also require a day

trading firm to provide a potential day trading customer with a disclosure

statement on the risks of day trading. A day trading firm’s risk disclosure

statement would be required to point out that day traders should be

prepared to lose all of their funds and that trading on margin may result in

losses beyond the traders’ initial investment. Specifically, information that

should be disclosed could include the following statements:

• Day trading is extremely risky.

• Be cautious of claims of large profits from day trading.

• Day trading requires knowledge of securities markets.

• Day trading requires knowledge of a firm’s operations.

• Day trading may result in paying large commissions.

• Day trading on margin or short selling may result in losses beyond the

initial investment.

Ensuring that day trading firms provide their potential traders an

appropriate risk disclosure statement does not address what firms tell the

traders orally. This presents a difficult challenge to regulators because

they generally do not directly observe the interactions between firms and

traders or potential traders. Also, unless they have a criminal investigative

function, the regulators are precluded from posing as potential traders to

test the oral disclosures firms provide.

 30 According to NASDR, a day trading strategy is an overall trading strategy characterized by the regular

transmission by a customer of intraday orders to effect both purchase and sale transactions in the

same security or securities.

Risk Disclosure Statement
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Page 27 GAO/GGD-00-61 Day Trading

Officials at some of the largest day trading firms have recognized

regulatory concerns and said that they have taken steps to mitigate those

concerns. For example, these officials said that they already screen

prospective traders; have improved the disclosure they provide; and have

restricted certain activities, such as customer-to-customer lending.

Although day trading firm officials generally agreed with regulators that

some day trading firms need enhanced oversight, they said they did not

believe that the abuses at those firms warranted the new rule proposals.

Most of these officials said that the proposed rules would not have much

effect on their operations because they were already complying with much

of what was being proposed.

Officials at six firms said that they screened potential customers to

determine if an individual was the type they wanted trading at their firms.

Although the criteria that each firm used were very subjective, all but one

of the firms’ officials said that they would not take just anybody off the

street who wanted to day trade. These officials said that potential traders

had to meet their firms’ initial capital requirements. Additionally, they said

that they would not allow the capital that individuals used to start trading

to be money that they would need to meet a mortgage or other important

expenses.

Some day trading firm officials expressed concern about the part of the

proposed appropriateness rule that dealt with promoting a day trading

strategy. They said their concern was that if they used the term day trading

in advertising, training seminars, or direct outreach programs and received

customers from such efforts, they could be subject to being sued by any

individual who lost money day trading. They also stated that regulators

were holding day trading firms to a higher standard than the rest of the

industry in that the suitability requirement that applies to the securities

industry applies only when a broker recommends a product. The

appropriateness rule, they contend, seems to apply more broadly than the

specific recommendation of a product required before the suitability rule

applies.

Another concern expressed by officials from these firms was that because

of the nature of day trading, it would be very difficult for them to

determine beforehand whether or not day trading was appropriate for

someone. They claimed that an individual would have to actually engage in

day trading before a determination could be made about whether day

trading was appropriate for the individual.

Day Trading Firms

Have Taken Steps to

Mitigate Regulatory

Concerns

Day Trading Firms Actions

Regarding Appropriateness
B-283097

Page 28 GAO/GGD-00-61 Day Trading

Officials from some of the firms we visited said that the appropriateness

rule would have very little impact on their firms. They said this was

because very few obtained day traders through advertisements or training

seminars, which are two ways the appropriateness rule indicates that a

firm would be promoting a day trading strategy. For instance, only two of

the firms offered training seminars. Most of the firms said that their traders

came to them through referrals. Furthermore, most of the firms said that

they did not promote day trading strategies. Instead, they educated traders

about how to limit their losses when trading. For example, some firms said

that they would start individuals trading by allowing them to trade in

increments of 100 shares. Once the traders learned how to limit their

losses, the firm would then allow them to trade increasing numbers of

shares.

According to officials at the seven firms we visited, they were already

implementing NASDR’s proposal that day trading firms be required to give

potential customers a risk disclosure statement, even though SEC had not

approved the risk disclosure proposal. Moreover, some of the firms had

some type of risk disclosure form before the rule proposal. For instance,

officials of one firm said they have had a disclosure statement since 1995,

and officials at another firm said they have had one since 1997. Officials

from both firms said that they had revised the form periodically. Five of

the firms had started requiring customers to sign disclosure statements in

1999.

In February 1999, before NASDR had issued its disclosure proposal, ETA

had proposed that its member firms adopt a risk disclosure statement. This

statement not only reflected the risk disclosures proposed by NASDR, it

also pointed out additional risks, such as the inability to liquidate positions

because of market conditions and the possibility of loss through systems

failures. As a result, one of the firms began to require its potential

customers to sign disclosure statements. When NASDR issued its proposed

appropriateness and disclosure forms in April of 1999 for comment, three

of the firms implemented risk disclosure forms similar to what NASDR had

proposed.

The disclosure forms of the seven firms that we visited generally appeared

to be in line with NASDR’s proposed risk disclosure. Those firms that had

not exactly copied the NASD proposal had covered risks that NASDR’s

proposal had not included. For instance, one firm had a statement that

persons who are new to electronic day trading should strictly limit both

the number of trades they do and the size of their trades to reduce the risk

of large dollar losses during the learning process. Another firm had a

Day Trading Firm’s Actions

Regarding Disclosure
B-283097

Page 29 GAO/GGD-00-61 Day Trading

statement that said the firm would neither make recommendations about

general market conditions nor recommend any particular transactions to

the day trader. It also said that all day trading decisions pertaining to the

trading of a stock or the timing of a transaction would be the individual’s

own decisions. However, none of the firms that had their own distinct risk

disclosure statement had mentioned that day trading through short selling

could result in losses beyond the trader’s initial investment. NASDR’s

recommended disclosure statement includes such a warning.

Officials at the seven firms we visited agreed that disclosing the risks of

day trading was very important. The general consensus was that if firms

disclosed the risks up front, they were limiting their liability in the long

run. Some of them clearly supported informing individuals about the risks

of day trading, and others said that when considered appropriate, they

tried to talk people out of day trading. A few of the firms said that

disclosure of the risk was not enough, and education about how the

securities markets worked was also important.

Three years ago the Federal Reserve amended Regulation T in a way that

permits firms to arrange loans from one customer to another or find third

parties who would lend to their customers. We found that day trading

firms and their traders have been fully utilizing the change in the

regulation. However, this type of lending at day trading firms has raised

concerns among regulators. At issue is whether some day traders are

allowed to continue to trade when they no longer have sufficient capital

and whether the traders understand the potential risks of these loans.

Margin rules generally limit how much customers could borrow to buy

stocks, but lending to cover margin calls enables traders to continue

trading when they otherwise might not be able to do so. The customer-tocustomer loans are generally made on an overnight basis to traders who

would otherwise face a margin call. The day traders who lend typically

receive interest payments equal to one-tenth of 1 percent daily, which

amounts to 36.5 percent on an annual basis.

Due to the increased regulatory interest regarding these loans, four of the

firms we visited had stopped allowing customers to lend to each other. Of

the firms that discontinued the practice, two did so because their clearing

firms would no longer allow the lending to continue. The three firms that

did allow customer-to-customer lending did not have a problem with the

practice. One official said that customer-to-customer loans allowed

individuals who accumulated wealth through day trading to move their

earnings into long-term growth investments such as mutual funds instead

of keeping the money at the firm.

Day Trading Firm’s Actions

Regarding Customer to

Customer Lending
B-283097

Page 30 GAO/GGD-00-61 Day Trading

Since it began in 1985, electronic day trading has been evolving in response

to various regulatory and market changes. At the time of our review, it

accounted for a growing segment of securities trading. Day traders provide

competition for market makers and institutional investors that may benefit

themselves and other individual investors. However, day traders may also

cause adverse market effects, such as greater volatility in stock prices.

Gaining a better understanding of the effects of day trading on the

individuals who engage in it as well as on the markets could help

regulators ensure that controls are in place to protect both.

The purpose of SEC’s and NASDR’s targeted examinations of the day

trading firms was to ensure that day trading firms adequately informed day

traders of the risks of their activities and had appropriate controls for their

ongoing operations. Although they did not find widespread fraud and

abuse in the industry, they found a number of problems, some of which

they referred to enforcement officials for further investigation. Day trading

is a particularly risky activity for individuals because they are competing

with professional traders and can potentially lose considerable money.

Further, the way day trading is done has changed rapidly and may continue

to evolve. The new rules proposed by NASDR address some of the

problems found during the reviews of day trading firm activities. However,

because day trading has become a growing part of the Nasdaq market and

because of the uncertain effects of such trading on investors and the

markets, continuing to target day trading firms for annual examination

could benefit both the traders and the market.

The actions taken by the seven largest day trading firms to improve

disclosure about the risks of day trading should help ensure that

appropriate information is available to a large percentage of prospective

traders. In addition, if the firms take the actions they plan to improve their

operations, including better screening of prospective traders; restricting

customer-to-customer lending; and enhancing compliance systems for

short selling, margin, and net capital, these actions should address a

number of the problems regulators have found. Ongoing implementation of

such controls by firms and oversight by regulators are important to ensure

that potential day traders understand that they are directly competing with

professional market makers and institutional traders and can lose as much

or more than they have invested.

Because the effects of day trading in an environment that depends less on

SOES and more on ECNs are uncertain, we recommend that the Chairman,

SEC, in conjunction with NASD, evaluate the implications of the growing

use of ECNs by day traders on the integrity of the markets. We recognize

Conclusions

Recommendations
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Page 31 GAO/GGD-00-61 Day Trading

that major changes are occurring in the structure of securities markets,

especially the change to decimal trading, and recommend that the

evaluation of day trading begin after decimal trading is implemented.

Also, day trading is risky for individual investors, represents a large and

growing portion of the Nasdaq trading volume, and is an evolving part of

the securities industry. Therefore, we recommend that the Chairman, SEC,

do at least one more cycle of targeted examinations of day trading firms to

ensure that the firms take the corrective actions they propose in response

to previous examination findings.

In commenting on a draft of this report, SEC concurred with our

conclusions and agreed to implement our recommendations. NASD said

that this report provided insight into the public policy issues related to day

trading. It also pointed out that our report covers a complex and changing

area where there may be different approaches on how best to protect

investors and ensure marketplace integrity. NASD also stated that it had

one substantive observation, that we had not addressed the impact of

margin lending practices on the profitability of day trading firms, which it

suggested merits further scrutiny. Although determining the impact of

margin lending on firms’ profitability may provide useful information not

only for day trading, but also for the securities industry as a whole, it was

not in the scope of our review. Both SEC and NASD provided technical

comments that we incorporated as appropriate.

We will provide copies of this report to Representative Tom Bliley,

Chairman, House Commerce Committee; and Senator Susan M. Collins,

Chairwoman, Senate Permanent Subcommittee on Investigations. We are

also sending copies to the Honorable Arthur Levitt, Chairman, SEC; and

Frank Zarb, President and Chief Executive Officer, NASD. Copies will be

made available to others on request.

Agency Comments and

Our Evaluation
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Page 32 GAO/GGD-00-61 Day Trading

Major contributors to this report are listed in appendix III. Please call me

on (202) 512-8678 if you or your staff have any questions about the report.

Richard Hillman

Associate Director, Financial Institutions

 and Markets Issues
Page 33 GAO/GGD-00-61 Day Trading
Page 34 GAO/GGD-00-61 Day Trading

Contents

1 Letter

Appendix I 36

Comments From SEC

Appendix II 38

Comments From

NASD

Appendix III 39

GAO Contacts and

Staff

Acknowledgments

Figure 1: Typical Trading Screen for Day Traders 12

13 Figures

Abbreviations

ECN Electronic Communications Networks

ETA Electronic Traders Association

LLC Limited Liability Corporations

NASD National Association of Securities Dealers

NASDR National Association of Securities Dealers, called NASD Regulation

NYSE New York Stock Exchange

SEC Securities and Exchange Commission

SIA Securities Industry Association

SOES Small Order Execution System
Page 35 GAO/GGD-00-61 Day Trading
Appendix I

Comments From SEC

Page 36 GAO/GGD-00-61 Day Trading
Appendix I

Comments From SEC

Page 37 GAO/GGD-00-61 Day Trading
Appendix II

Comments From NASD

Page 38 GAO/GGD-00-61 Day Trading
Appendix III

GAO Contacts and Staff Acknowledgments

Page 39 GAO/GGD-00-61 Day Trading

Richard J. Hillman (202) 512-8678

Michael A. Burnett, (202) 512-8678

In addition to the persons named above, Tamara Cross, Edwin J. Lane, Bob

Pollard, and Gregory True made key contributions to this report.

GAO Contacts

Acknowledgments
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